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Understanding the FOMC Report

Understanding the FOMC Report

The Federal Reserve, also referred to as the Fed, is the central banking system of the United States and is responsible for guiding U.S. monetary policy. Economic policy announcements and public statements by the Federal Reserve are among the most highly anticipated trading events of the year, since implications for financial markets are so widespread.

The Fed is responsible for buying and selling U.S. government securities in the financial markets and setting interest rates and reserve requirements. The Fed by definition is dual-mandated, Fed policy makers are expected to achieve both stable prices and maximum employment. As a result, public statements made by the Fed and its governors are closely watched by traders, since even the smallest changes in monetary policy and federal funds rates can create large market-moving events.

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) consists of twelve members: the seven members of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

For traders, FOMC meetings are a time of particular volatility because any change in federal fund rates can affect a range of economic variables such as short-term interest rates, foreign exchange rates, long-term interest rates, employment output and prices of goods and services.

The FOMC meets eight times a year to discuss monetary policy changes, review economic and financial conditions and assess price stability and employment output. These meetings take place every six weeks. Four of these meetings feature a Summary of Economic Projections (SEP) followed with a press conference by the chair. The minutes of the scheduled meetings are released three weeks after the date of the policy decision.

Trading on the Fed’s Decisions

The Fed provides a wealth of data that can influence the markets. In addition to the Fed’s headline interest rate, traders also study the post-meeting press releases, which highlight the state of the economy. Since some information contained in the press release may look forward to policy changes at future meetings, the contents of this release carry a risk of catching market participants off guard. It is for this reason that traders pay particular attention to press releases, speeches and other public appearances by Fed members that occur between FOMC meetings.

There are a number of factors to think about when trading before and after FOMC meeting announcements, but with a little insight and thorough preparation it is an event that offers numerous opportunities for traders throughout the year.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Trading the Link Between USD/JPY and U.S. Treasury Securities

In the latest Trader’s Edge video, we explore the relationship between U.S. Treasury securities and the USD/JPY exchange rate, and the opportunities it can present with Treasury yields on the rise. Topics include:

Recent weakening of the U.S. dollar vs. the Japanese yen
Why rising yields in U.S. rates have not strengthened the dollar
How a higher yield and weaker dollar affects Japanese holders of U.S. Treasuries
Why Japanese investors could be on verge of selling U.S. Treasuries
How higher Treasury yields could help strengthen the USD/JPY exchange rate

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Trading the U.S. Treasury Curve: Twos versus Tens

The U.S. Treasury Bond market is the largest and deepest government debt market in the world. Individual U.S. Treasury Notes and Bonds provide important benchmark yields at various points along the yield curve.

Trading the slope of the U.S. Treasury curve using futures contracts involves the execution of an inter-commodity spread. One very common and widely quoted yield curve spread is the twos versus tens yield spread. This spread compares and reflects the difference in yields between the current U.S. Treasury 10-Year note and the current U.S. Treasury 2-Year note.
Watch this video to learn more about this spreading technique.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Treasury Intermarket Spreads – The Yield Curve

Once you understand how to calculate the basis point value (BPV) of a U.S. Treasury futures contract and dollar-weighted hedge ratios versus other fixed income securities, it is short walk to how to spread one contract versus another.

Understanding Spread Trades

A spread trade is one where the trader buys one and simultaneously sells another highly correlated futures contract. Spreads can be intra-market, like a time spread, also known as a calendar spread, buying one month and selling another of the same product. Or spreads can be constructed between similar products like buying corn and selling wheat.

Within the U.S. Treasury futures complex it is very common to spread one U.S. Treasury contract against another. Because CME Group lists multiple U.S. Treasury futures based on targeted maturities (2-year, 5-year, 10-year, Ultra 10-year, Bond and Ultra-Bond) traders can construct spread trades to express a point of view on the slope of the yield curve.

The Yield Curve

U.S. Treasury securities are traded based on price, but also reflect a corresponding yield-to-maturity (YTM). If you were to take all of the government securities and plot them on a grid with the x-axis showing their maturity dates and y-axis showing their yield-to-maturity you would end up with what looks like an upward sloping pattern left to right.

The grid of yields versus maturity is known as the U.S. Treasury yield curve, or simply the yield curve, . Normally quoted using the most recently auctioned U.S. Treasury securities called on-the-runs (OTR), the yield curve expresses the yield difference between various points along the curve.

For example, one frequently quoted yield spread is the difference between the 2-year note and 10-year note. If you were told the 2/10 yield curve was 150 basis points that would generally mean the yield of the 10-year was 150 basis point higher than the yield of the 2-year note.

Yield curves can be positively sloped, flat or negatively sloped (inverted). When a trader or risk manager places a yield curve trade she is more concerned with the relative value, or difference in yields, between the securities than whether absolute yields rise or fall.

Traders can and do express opinions on the U.S. Treasury futures yield curve by spreading one U.S. Treasury futures contract versus another. Looking back at the 2/10 spread mentioned above, a similar trade could be constructed using futures contracts.

Building a Spread

The spread begins with what we already know about U.S. Treasury futures, they trade like their CTD securities and we can calculate their implied BPV.

If we wanted to buy a 2/10 yield spread using futures, we must first identify which U.S. Treasury futures contracts we want to use to build the spread. We know there is a 2-year futures contract but what about the 10-year side?

There are two futures contracts listed by CME Group that derive their value from 10-year U.S. Treasury securities, the Classic 10-Year and the Ultra 10-Year. Which should we use? The Ultra-Ten Year tracks a CTD that trades closer in maturity to the OTR 10-year so we will use it for our example. So for our example we would buy the 2-year future and sell the appropriate number of Ultra 10-Year futures.

The second step is to identify each contract’s CTD issue, then, based on its CTD’s BPV and conversion factor, calculate each contract’s implied BPV. Then we can compare the respective BPVs and, with a little math, arrive at the appropriate spread ratio (SR). Mathematically it would look like this:

Spread Ratio (SR) = BPVultra-ten ÷BPV2-year

Assume that the 2-Year (TUH7) has a BPV of $46.25 per contract and the Ultra 10-Year (TNH7) has a BPV of $128.78. Plug this into the formula above and we get:

SR= 128.78 ÷ 46.25 = 2.78, or roughly 3:1 TUH7 to TNH7

By buying three TUH7 contracts versus one TNH7, this spread is effectively dollar-neutral. That means it is less subject to profit and loss based on direction of the market and more subject to change in the yield difference between the contracts. This trade is about changes in slope rather than changes in outright yield. Because U.S. Treasury futures prices move in an inverse relationship to yield, if one is buying the 2/10 they are anticipating the slope to steepen, or increase, between 2/10s.

We recognize traders and risk managers utilize U.S. Treasury futures to trade the slope of the yield curve and conveniently list yield curve trades weighted and rounded to whole number ratios on our website and on CME Globex.

Summary

Yield curve trades are a common and frequently executed trade in both cash and futures U.S. Treasury markets. They can provide added value to risk managers and traders alike. Understanding the pricing and trading behavior of CME Group U.S. Treasury futures contracts and how they relate to the underlying cash Treasuries is essential to using them effectively.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Treasuries Hedging and Risk Management

Hedging interest rate risk with CME Group U.S. Treasury futures begins with identifying the futures contract’s CTD security. Once identified, we can determine the implied basis point value (BVP). BPV is also known as value of a basis point (VBP) or dollar-value of an .01 (DV01). They all refer the same thing, the financial change of the security or portfolio to a change in a 0.01% change in yield. To construct the proper dollar-weighted hedge ratio versus the product or position at risk we need to first determine the BPV.

Calculating Basis Point Value

The calculation for the BPV is simple: the contract’s CTD BPV divided by the CTD conversion factor (CF).

BPVcontract = BPVctd ÷ CFctd

Once we have the BPV, all we need is the BPV at risk.

Example

Assume you are long $100 million of a U.S. Treasury portfolio with an average BPV of $450 per million. This BPV is closest to the BPV of the CME Group U.S. Treasury 5-Year Note futures contract so we will use it as our hedging instrument.

The CTD for the 5-Year contract versus the March 2017 expiry is the 1.375% of May 31, 2021. It has a BPV of 42.45 per $100,000 face value and a conversion factor of 0.8317.

We use $100,000 because that is face value of one 5-Year Note futures contract. Our risk position is quoted in million-dollar increments so we will make a slight multiplication to adjust apples for apples.

For our example, we have the following: BPVcontract = 42.45 / 0.8317 = $51.04

The next step is to determine the value at risk. Our portfolio was $100 million and the average BPV per million was $450. Therefore, 450 x 100 = $45,000 value at risk.

Now we can calculate our hedge ratio. We will use the following formula:

Hedge ratio (HR) = Value at risk ÷ Value of contract, or

HR = BPVrisk ÷ BPVcontract

HR = 45,000 / 51.04 = 881.66 or 882 5-Year futures

Because we are hedging a long position that is exposed to higher interest rates we would sell the futures contracts.

It would be highly unlikely for a portfolio manager to hedge her entire risk position. That would effectively leave her with no rate exposure. In other words, if rates went lower, she would not participate in the capital gain of higher prices. Usually risk managers of large rate positions use futures contracts to hedge a portion of their risk or to modify their portfolio’s target duration.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Calculating U.S. Treasury Pricing

Treasury Price/Yield Calculator

Pricing U.S. Treasury bonds, notes and futures can look at first glance to be much different than the pricing of other investment products.

Cash bonds and futures based on U.S. Treasury securities do not trade in decimal format but in full percentage points, plus fractions of a 1/32 of par value. For example, if you were to see a quote on a broker/dealer screen showing U.S. Treasury prices you might encounter something like this:

10 YR 2.250 2/15/27 99-032 / 99-03+ 10/20

This quotation would indicate the current on-the-run (OTR), or most recently auctioned, 10-year note with a coupon of 2.250% and a maturity date of February 15, 2027 is currently 99-032 bid and offered at 99-03+, $10 million bid with $20 million offered.

The bid-side price of 99-032 is not 99.032 but rather 99 full points of par value plus 3.25 1/32s of a point. In the cash market, the third digit might be two, plus or six. The two constitutes 2/8, or ¼, of a 1/32. A plus constitutes ½ of 1/32, and six constitutes 6/8, or ¾, of 1/32. So our bid-side quote converted from 1/32 to a decimal would be: 99-032 (1/32s) = 99.1015625, or 99.1015625 percent of par. The offer-side price would convert to 99-03+ = 99.109375.

If you were to view a U.S. Treasury futures price quotation you might encounter something like this: TNM7 134-010/134-015.

The same concept as the cash market convention applies. The bid-side quote represents 134 full points plus 1/32 of a point. The converted price into decimal would be 134-010 = 134.03125, and so forth for the offer-side price. In futures you might see 134-012 for 1-1/4 (1/32), 134-015 for 1-1/2 (1/32), or 134-017 for 1-3/4 (1/32).

While seemingly complicated, it becomes second nature after a while. Cash Treasuries and futures based on U.S. Treasuries trade in points and fractions of points (1/32). But when doing any mathematical calculations, we must first convert from 1/32 to decimal, do the calculation, then convert back to 1/32 price convention.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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How Can You Measure Risk in Treasuries?

When it comes to measuring risk for fixed income (rates) traders and portfolio managers, they tend to use one or two yardsticks, value of a basis point and modified duration.

Value of a basis point (VBP), also known as basis point value (BPV), or, for U.S. dollar products, dollar-value of an 01 (DV01),is the financial effect of a 0.01% (one-basis point) change in that instrument’s yield.

For example, if a 10-Year note is current 1.30% yield to maturity with a DV01 of $859 per million par value and the yield goes up by 0.01 to 1.31%, we would expect the financial value of that note to drop by $859 per million par.

DV01

One can identify the DV01 of individual securities or an average DV01 of a whole portfolio. DV01s tend to get larger as you move out the yield curve.

For example, a 2-Year U.S. Treasury note may have a DV01 of $185 per million par while a 30-year Treasury bond may have a DV01 or $2,131 per million par.

Modified Duration

Modified duration represents the financial effect as a percentage gain or loss to a 1.0% (100 basis points) change in underlying yield.

For example, consider our previously mentioned 10-Year note: if its duration was 8.95 years and yields move higher from 1.30% to 2.30%, or by 1.0%, we would expect the value to fall by 8.95% in value.

Treasury	DV01
Ultra 30-Year	$289.34
30-Year	$213.14
Ultra 10-Year	$115.84
10-Year	$76.55
5-Year	$47.94
2-Year	$36.97

In general, the longer the maturity, the greater the price sensitivity and risk. Duration measures this risk precisely.

Traders and portfolio managers routinely refer to your position or portfolio in basis point value and modified duration terms.

Implied Basis Point Value and Implied Duration

U.S. Treasury futures can also be referred to in implied duration and implied basis point value terms.

To look more closely at the BPV and modified duration of a futures contract, we must first go back to the concept of a U.S. Treasury futures contract’s cheapest-to-deliver (CTD) security. You may recall from previous modules a U.S. Treasury futures contract’s CTD security is the eligible bond or note that is most financially efficient for the short position to deliver to the long position at contract expiration. Very few market participants go all the way to delivery, in fact the number is quite low (usually less than 5% of open interest).

The reasons we want to know about the CTD security is two-fold: contracts trade like their CTD security and we will use the CTD security and its conversion factor to arrive at that contracts implied BPV.

Once we know a U.S. Treasury’s CTD security we can determine that security’s BPV per $100,000 face value (or $200,000 face value in the case of 2-Year note futures). We use $100,000 because, with the exception of 2-year notes which have an underlying face value of $200,000 per contract, U.S. Treasury contracts have an underlying face value of $100,000 per contract.

Once we know a contract’s CTD we can determine its BPV; and using that security’s conversion factor (CF) and some simple mathematics, arrive at the implied BPV.

Assume we have a 5-Year Note futures contract and its CTD security is the 1.375% of May 31, 2021 with a BPV per $100,000 of $42.45 and a conversion factor of 0.8317.

To arrive at the BPV, we take the BPV of CTD and divide it by its conversion factor:

BPVcontract = BPV ctd ÷ CF

For our example, BPVcontract = 42.45 / 0.8317 = $51.04 per contract.

Once we have the implied BPVs for the U.S. Treasury futures contracts we can use them to calculate appropriate dollar-weighted hedge ratios versus a cash security of portfolio. We could also calculate the spread ratios between futures contracts so we can construct dollar-weighted yield curve trades.

Interest rate traders and managers of risk use basis point value and modified duration to measure their market risk. Futures contracts based on U.S. Treasury securities can also be referred to in implied basis point value and implied modified duration with a little knowledge of how the contracts price and behave and some simple math. Knowing the contract’s CTD is the starting point.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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